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Morgan Stanley FICC Cuts May Go to 2017, Chen Says

Morgan Stanley may continue cutting assets in its fixed-income business for another five years as it seeks higher returns, said Howard Chen, a Credit Suisse Group Inc. analyst.

Morgan Stanley must return capital freed up by the reductions to shareholders, buy the rest of its brokerage joint venture and lower its funding and operating costs, New York-based Chen wrote in a note to clients yesterday. Achieving those goals can allow the firm, which will probably produce a 5 percent return on tangible equity this year, to earn a 9 percent ROTE even without an improving environment, Chen said.

Chief Executive Officer James Gorman pledged to improve returns as his bank’s stock has lagged below its book value for more than two-and-a-half years. Gorman, 54, said in October that it didn’t take “heroic assumptions” to see how his plans will get the New York-based firm’s returns to its cost of capital, usually estimated at around 10 percent.

“We believe franchise restoration, healthier market conditions and the absence of new negatives from here should drive further share-price outperformance,” Chen wrote. “Further proof points and effectuation of the ROTE expansion plan, with hopefully a better revenue backdrop, will drive a re-rating of Morgan Stanley shares from still depressed valuations.”

Morgan Stanley has laid out a plan to cut risk-weighted assets in its fixed-income business, which were $390 billion a year ago, to $255 billion by the end of 2014, under Basel III rules. The firm will probably continue to wind down “longer-duration exposures” for years after that to arrive at less than $200 billion by 2017, Chen said.

Cost Savings

The bank has about $46 billion of non-productive assets based on its low fixed-income revenue relative to its peers and its size, Chen estimated. Those assets, including uncollateralized over-the-counter derivative trades, face heavy risk-weightings and may account for one-third of the firm’s $320 billion in RWAs.

Almost half of the estimated increase in the firm’s returns will come from expense reduction, Chen wrote. The bank has targeted $1.7 billion in cost savings over the next two years from actions including completing the integration of its brokerage and reducing the number of employees, he wrote.

Morgan Stanley can also increase pretax earnings by about $370 million by buying the rest of its brokerage joint venture and using the deposits gained to replace $22.5 billion of maturing long-term debt over the next two years, Chen wrote.

There’s a “decent likelihood” Morgan Stanley will buy Citigroup Inc.’s remaining 35 percent stake in the brokerage next year, Chen said. Improvements in that business represent a “low-risk” way to improve the firm’s returns, he wrote.

Morgan Stanley can raise earnings from its brokerage by increasing lending and boosting adviser productivity, Chen said. Mark Lake, a Morgan Stanley spokesman, declined to comment on Chen’s note.

Morgan Stanley gained 0.6 percent to $17.80 in New York. The shares have climbed 18 percent this year, compared with a 23 percent advance in the 81-company Standard & Poor’s Financial Index.

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